How common biases can mess with spending decisions

There is an old poker saying that if you can't spot the sucker in your first half-hour at the table, then you are the sucker. That describes the bias blind spots everyone has.

The question isn’t, “Are we biased?” We are. The better question might be, “How does our environment — and positive and negative reinforcements within it — shape our perspective?” Those influences define how we think, feel and respond to information. Unfortunately, we can detect biases more readily in others than we can in ourselves.

When individual decision-makers come together to make choices, the interplay of biases creates factions and alliances that stalemate progress or hijack agendas. To break logjams or neutralize groupthink, leaders often become autocratic. Those who agree with the leader become confident and satisfied; those who oppose the leader feel disempowered and might become passive-aggressive. No one wins.

Three common biases affect capital allocation decisions: framing effect, confirmation bias and planning fallacy. Here’s how to spot them and minimize their effects.

* Framing effect. The way a question is framed has an impact on choices. Implied certainty and positive or negative language can sway opinion. For example, would you prefer option A, which has a $1 million net present value? Or option B, which has a 33 percent chance of a $3 million NPV and a 66 percent chance of a zero NPV? Both projects have the same expected value, but project B appears more risky.

To counteract the framing effect, challenge assumptions and reframe options to break through the predispositions the frame imposes.

* Confirmation bias. Our minds seek patterns and similarities and selectively choose information that supports existing assumptions and beliefs. In experiments, a group given the numbers 2, 4, 6 almost all look at the underlying rule of increasing by two when, in fact, the rule being tested is simply successive larger values.

Consider comments such as, “Didn’t we get a positive result from that test on option A?” and “We tried a similar approach to option B before, and it was a disaster!” The parties to the decision have already begun trying to frame the decision.

To combat that effect, a devil’s advocate in the group should express counterpoints. Use outsiders who are not vested in the outcome, or use a structured approach for new opinions and contrary positions.

* Planning fallacy. The planning fallacy is known to anyone who has heard of projects being years behind schedule and millions or even billions of dollars over budget. The Sydney Opera House in Australia was expected to take five years to build from the start in 1959 and cost $7 million. It was completed in 1973 (14 years later) at a price tag of $107 million (15 times the original estimate).

Even the most conservative estimates are often optimistic. To manage the planning fallacy, estimate project costs and timing in terms of best, expected and worst case. Then make the worst case the best case to see if it changes the decision. Run net present value or schedule simulations with a range of values for cost and time variables. Run them again for comparison, with ranges approximately twice as wide as you initially believed them to be.

Biases can distort our perceptions and encourage wishful thinking. A problematic frame, talking ourselves into wishful benefits and optimistic planning lead to poor results. Watch for those common effects and their potential pitfalls, and implement countermeasures to help make sure you pursue the best course of action.